We’re not big into analyzing the stock market. It’s not our thing, and there’s little evidence the people whose thing it actually is are any good at it. However, a +30% return by the S&P 500 last year is hard to ignore, and there’s been a collective focus among investors and those in the financial industry alike to answer the question most all of us are unable to accurately predict: Where will the stock market go from here? Is a market correction in the works, or are we going to be seeing “All Time Highs” on CNBC each week for the coming months?
Enter the week after MLK weekend (which has a history for falls in the markets), and the question has never been more relevant, with sell offs in emerging markets spilling over into the US Stock rally machine – with the S&P 500 dropping 2.6% percent (hardly a crash, but after the near perfect up trend in 2013, enough to scare quite a few people) while the Dow dropped an even worse 3.5% last week (and more losses today in a back and forth session). So are the bears right? Is this the start of a new down turn in the markets like we saw in 2009? Or is this just a normal pullback… the market taking a proverbial ‘breather’.
Which leads us to our title question…is it time to start thinking about protecting your portfolio a bit? Is it time to scale back some on stocks and consider some alternatives? Is it time to Google ‘Alternative Investments’ ?
There were likely more than a few people searching Google for “Alternative Investment Opportunities” with the Dow down over 600 points in a few days.
But just what are they looking for, exactly? Something which isn’t going down..that day? Something which can make money if there is an extended down move? Something which has different return drivers than the stock market – thus don’t rely on stocks going up or down for their own performance? Hedge Funds? Commodities? Real Estate? Put option protection? Inverse ETFs? Gold coins? Diamonds? Art? Classic Cars? Wine?
Turns out the term ‘alternative investments’ is rather broad, with many so called alternatives (gold coins, wine) not things you’re going to see covered on the Chartered Alternative Investment Analyst Curriculum or in the lineup of Alternative ETFs at a shop like ProShares. Indeed, a Russel Investments survey found there are really just four types of ‘alternative investments’ as considered by institutional investors (source: CAIA).
Now, these four types of investment may be considered “alternative” by many, but it seems they are labeled as such not because they zig when the stock markets zag; but more so because they just aren’t all that common in the typical investor portfolio. The numbers show us many hedge fund strategies and private equity, in particular, have a lot more stock market exposure than one would think with the moniker ‘alternative investment’.
Now, real assets include mostly real estate, plus some land and infrastructure plays like timber or farmland. And real estate is definitely different than the stock market and squarely in the alternative investment camp – but unlike some other types of alternatives, real estate is pretty closely tied to how the global economy is performing (turns out people need money to buy houses and keep paying their mortgages and stuff, and that the money comes from their jobs, which are sort of tied to how well companies are doing, which is sort of tied to how company’s future prospects are, which is what their stock price is based on.. in part). Yep – real estate is alternative right up until it isn’t – at which point it is highly correlated with the stock market (see 2008).
Commodity markets sure seem like a slam dunk, no brainer alternative investment. After all, what does Soybean Oil have to do with Microsoft’s earnings and stock price? And most of the time, commodities are definitely an alternative investment doing things much differently than the stock and bond markets. Corn, Cattle, Natural Gas and Crude Oil all respond to price drivers such as: crop reports, weather (winter storms), international relations with the Middle East, and the basic economics of supply and demand. But upon closer inspection – the stock market is somewhat infested with commodity based companies: the ExxonMobils, Alcoas, ADMs, Monsantos of the world, and slew of other companies dependent on the farming and mining of commodities (Caterpillar, John Deere, etc). This blurring of lines between commodities and commodity companies causes some higher than normal correlation between commodities and traditional investments – especially if you are overweight in the energy or mining sector; but the real danger is something much simpler. The real danger to commodities as an alternative investment is the simple fact that we use more of these commodities in the boom times than we do in recessions. This became known as the risk on/risk off trade in 2008 and 2009 – when Crude Oil, Copper, Corn, and other commodities sold off right along with stocks; and then started to rise right along with them when the global economy saw signs of life. Commodities were decidedly not an alternative investment during the last crisis because of their tie in with the global economy.
Private Equity is a bit of a hybrid. On the one hand, it is a bit of an odd investment to call ‘alternative’ – with equity right there in the name (semi joking). It’s investment strategy is to gain shares (equity) in privately held companies via outright purchases, debt deals, financing, and more; looking to off-load those shares to someone at a higher price at a later time, which sure sounds like the same model as the stock market. On the other hand, private equity is usually investing in private companies, not publicly traded – and may be in at the very beginning and able to capitalize on the rapid growth of a company in its early stages (which can decidedly be outside of whatever the general market is doing). The excellent book ‘The Invisible Hands’ by Steven Drobney does a good job of explaining the return driver for Private Equity – which he believes is an illiquidity premium, but we’ll sum up private equity with the words of tweeter extraordinaire Josh Brown:
And then there are the many layers of hedge fund categories which are marketed as alternative investments but which in actuality are just more sophisticated (or complex, or both) ways to access the return stream of private and public companies around the world (i.e. the same thing which drives the stock market). In addition, many hedge funds rely on access to the credit markets to amplify their returns or even as part of their overall investment strategy, meaning any stock market decline caused by tightening credit markets is going to cause problems at the hedge funds as well. All of these factors combined to leave nearly all hedge fund strategies, be it long/short equity or merger arbitrage or event driven, down in 2008 when the stock market crashed. Now, they still did better than the equity markets themselves… which makes them a better investment for your stock market exposure in our opinion – but nonetheless still gives you stock market exposure, the good and the bad.
(Disclaimer: Past performance is not necessarily indicative of future results)
Source: Market Folly
Which leads us to our favorite alternative investment, an investment that wasn’t part of the “Major Alternative Asset Categories” per the Russel Investments survey mentioned earlier, as it is often considered at different times part of the commodities and/or hedge fund category. (which coincidentally are currently out of favor after the big 5 year up move in stocks). We’re talking Managed Futures and their hedge fund cousin global macro hedge funds, of course. These types of alternative investments actually do what one would expect out of an alternative – something different. You can see the 2008 performance in the table above and performance in many different crisis periods in the chart below.
But more important to us than how they have done in past market crisis periods, is why they did so – and that why comes back to a) What they Trade, b) How they Trade it, and c) When they Trade it.
For a) ‘What they Trade’: managed futures trade futures markets on essentially all major market sectors – including commodities (grains, energy, metals, meats, softs), currencies, stock indices, and bonds – meaning they are not reliant on any one of those sectors (or a single company or sector within those sectors) to move a certain direction for their returns.
For b) ‘How they Trade it’: managed futures have the ability to go both long and short; meaning they can make just as much money from Crude Oil going from $120 to $90, as they can from Crude Oil going from $70 to $100.
And finally, for c) ‘When they Trade’: the majority of managed futures is systematic (a big different from Global Macro), meaning you aren’t relying on a single person or team of traders to identify a new trend up or down, the investment program is continuously analyzing the full portfolio of markets and entering into the trades automatically – insuring a lot of losses (such as current period) when the trends don’t materialize; but also insuring that the program is involved in the outlier trade when it does happen.
(Disclaimer: past performance is not necessarily indicative of future results)
Managed Futures = DJCS Managed Futures Index
U.S. Stocks = S&P 500 Total Return *from Jun 1994 to June 2013
Absolute Return or Diversifier or Hedge
In the end, what type of alternative investment you’re looking for really depends on what you want it for. If you’re looking for returns, period – and not so concerned with how correlated it is to the stock market – the equity like returns of private equity or a market neutral or long/short equity hedge fund may be appealing. If you want the returns, with no correlation to the stock market – a specialty managed futures program such as a short term program or Ag Trader or option trader may fit the bill.
But if you are looking for a portfolio diversifier or even outright hedge against your stock market exposure – then the grand majority of so called alternative investments just aren’t going to fit the bill. The grand majority, including private equity, hedge funds (most), real estate and commodities (in extreme examples) will show equity like returns during a crisis – because they are reliant on global demand, which can quickly go on strike as we saw in 2008.
You can buy put options on your stock portfolio, or exit your stock portfolio altogether to hedge against a stock decline – but those come with real costs such as premiums and more nuanced opportunity costs, the timing of selling out of stocks. And you can be in cash or bonds… but that is hardly alternative, that should already be part of a diversified portfolio.
Or you can look at managed futures as your diversifier, attempting to find a program which has the characteristics to allow for it to provide the crisis period performance when it is needed – while also having the ability to perform some in a rallying stock market in sort of a best of both worlds. An imperfect option on a market crash, but one which also allows for the ability to get paid on the hedge before it is needed – a sort of insurance policy that can pay for itself. Of course, the insurance policy could also lose before its needed and cost more than the simple put buying strategy – nobody said this was easy. It’s a tough task to be sure, but to the victors go the spoils… And you don’t have to go it alone, that’s why we’re here to help.
So as you head down whatever path Google leads you down after your fateful search on ‘Alternative Investments’, make sure you check the signposts to make sure you know what path you’re headed down. It may be marketed as an alternative path, but in fact a parallel path to the stock market journey you’re already on. And maybe you’re fine with that… Maybe that works for you. But if you’re after something truly different, something truly alternative; make sure you’re getting what your after with your ‘alternative investment’.